The European Central Bank's meeting

Back to forward guidance

IN NOVEMBER the European Central Bank caught markets on the hop when it cut interest rates, bringing down its main policy rate from 0.5% to 0.25%, a new low. But having made the move a month earlier than expected it came as no surprise today that the ECB left interest rates unchanged.

One reason why the markets had expected a decision to cut interest rates in December rather than November was that the bank’s governing council would have available for the first time a forecast for 2015 as well as an updated forecast for 2014. These are produced twice a year, in June and December by staff from the Eurosystem (the ECB and the 17 national central banks); projections are also provided in March and September by ECB staff. Today’s include more detail than before, such as forecasts for core inflation (ie excluding more volatile prices like energy and food); and they also include fiscal projections for the first time.

The new forecasts show a meagre recovery from the euro zone’s protracted double-dip recession. After contracting this year by 0.4%, GDP will increase by 1.1% in 2014 (marginally higher than the 1% foreseen in September) and by 1.5% in 2015. Moreover, Mario Draghi, president of the ECB, said in the press conference that the risks to growth were on the downside.

But the main focus was on the forecasts for inflation, since it was concern about weak inflation which led to last month's rate cut. Ahead of the November meeting inflation had slid from 1.1% in September to 0.7% in October. Since then it has recovered a little, to 0.9% according to Eurostat’s preliminary estimate published on November 29th. But the new forecasts still painted a rather worrying picture, with headline inflation for 2014 now expected to be just 1.1% (down from 1.3% predicted in September), picking up to 1.3% in 2015. Core inflation will be just a bit higher, at 1.3% in 2014 and 1.4% in 2015.

That is a long time for inflation to remain well below the ECB’s target of “below but close to 2%”. With euro-wide inflation so low, countries on the periphery find it harder to regain lost competitiveness without lurching into deflation themselves, which makes it more difficult for them to deal with excessive debt burdens. But with the ECB’s main lending rate now at 0.25%, the bank is now essentially out of conventional ammunition. Further steps to stimulate the economy and to arrest a further slide in inflation will require unconventional weapons, such as introducing negative deposit rates – charging banks for parking funds with the ECB; or quantitative easing – buying assets with newly created money; or a new long-term funding programme for banks that is tied to their lending to the private sector.

Mr Draghi was keen to reinforce the message he sent a month ago: that the bank still has policy arrows in its quiver. The council was ready and able to act, he said, within the context of its forward guidance first set out in July – that the bank’s key interest rates will remain at present or lower levels for an extended period of time. But he was reluctant to go into any detail.

That very reluctance offers some forward guidance in itself. Even the decision to cut interest rates last month was contested within the council. A move into unconventional territory through for example negative deposit rates would be much more divisive. The ECB would rather get its way by influencing expectations through threats than through action.